Fed Watch: More Easing Expected

The FOMC performed as expected yesterday, delivering a 50bp cut that returns rates to their lows of the Greenspan era. More importantly, Bernanke & Co. made clear that further policy easing remains on the table.

The FOMC statement describes an economy in recession without actually using the “R” word:

The pace of economic activity appears to have slowed markedly, owing importantly to a decline in consumer expenditures. Business equipment spending and industrial production have weakened in recent months, and slowing economic activity in many foreign economies is damping the prospects for U.S. exports. Moreover, the intensification of financial market turmoil is likely to exert additional restraint on spending, partly by further reducing the ability of households and businesses to obtain credit.

Any other assessment would have been surprising; by all measures, economic activity fell off a cliff as we entered the second half of this year. Yesterday’s durable goods report is no exception, with nondefense, nonair capital goods declining 1.4% in September, extending a 2.2% decline the previous month. The intensification of the credit crunch (yes, Virginia, it is a crunch), increased hesitation to expand capital outlays in the current environment, and slowing global growth suggest that investment activity will show even greater declines in the months ahead.

Consistent with the darkening outlook, the incoming flow of data is likely to be horrid, especially during the next two quarters. In particular, the employment report will soon reveal the big declines in nonfarm payrolls consistent with a recession. An increased pace of job losses will sap aggregate household budgets of the real gains afforded by falling energy prices. Consequently, spending data will remain weak. Overall, the data will argue for additional policy response, and the Fed’s statement makes clear that they are prepared to ease policy further as required.

But will that easing come in the form of lower rates? And how far would the Fed go?

Brad DeLong reminds us that the Taylor Rule places the policy rate at zero, but there is some concern that rates lower than 1% will interfere with the normal operations of money market funds – they need to remain profitable if the Fed expects them to continue to function.

Also note that only four district banks requested a decrease in the discount rate, which some believe indicates the rate cut cycle is near its end, or that there was less support than the unanimous vote would seem to indicate. If so, expect some hawkish talk from district presidents.

Still, unless the Fed believes that technical reasons prevent moving much below 1%, I doubt anything short of a dramatic improvement in financial markets would eliminate the possibility of another rate cut. Even under such conditions, the pressure to ease further will be immense as labor markets deteriorate (this has always been a risk of the Fed’s aggressive push).

But suppose that conditions warrant a prolonged period of constant rates. In the current environment, even holding rates at 1% is not the same as the end of the easing cycle. Indeed, the effectiveness of rate cuts at this point is questionable.

The reaction of market participants to the coordinated 50bp cut earlier this month was not exactly a vote of confidence in the efficacy of this particular policy tool. Given the ongoing problem in financial markets, are any of us under an illusion that the price of money is the dominant policy challenge? How many believe that the final 100bp will have a measurable impact on economic activity?

This is especially true with regard to the near term; if the last 100bp has much effectiveness left, the impact will not be felt until late next year. That is not meant to say that we should reverse course and start raising rates. Only that future policy easing will be more about the extension of tools that increase the Fed’s balance sheet rather than on the level of rates in the overnight markets.

Of course, expanding the balance sheet, effectively replacing liquidity that is drying up in various parts of the financial markets (by, for example, purchasing commercial paper), should not be seen as a panacea to the current turmoil. I view it, along with Treasury’s capital injections, as more of an effort to prevent the turmoil from leading to an outright collapse in the banking system rather than something that will increase lending.

Policymakers would be happy to see lending activity expand. But deleveraging threatens to dry up credit at a pace faster than the Fed and Treasury can compensate. Moreover, a portion of the credit crunch is attributable to a reversion to traditional underwriting standards; policy will be unlikely to reverse this trend (nor should it). And, with economic conditions deteriorating, and unemployment expected to rise, banks will increase their loan loss provisions, further weighing on lending activity. In short, at best, Fed and Treasury can limit the extent of the crunch, and hopefully prevent significant overshooting.

With the reversal of commodity prices since the summer, policymakers no longer worry about inflation. This provides room for additional easing, although some think it is shortsighted:

With today’s cut the Fed is throwing gasoline on an inflationary fire that it created but continues to ignore. The Fed has mistaken temporary drops in commodity prices, which merely resulted from de-leveraging, for clear evidence that the inflation menace has been quelled. However, once highly leveraged players have been flushed out, commodity prices will resume their ascent, pushed skyward by the most inflationary monetary policy in history. –Peter Schiff, Euro Pacific Capital

The argument is that underlying conditions place the dollar’s newfound gains at risk of another reversal. Once the deleveraging is complete, foreign investors will realize they are now awash in dollar denominated assets at a time when the US Treasury is expected to unleash an unprecedented quantity of such assets on global financial markets. The dollar and commodities will reverse direction accordingly.

I admit to being sympathetic to this story, but would note that sufficient slack looks to be opening up in the global economy to absorb these assets (especially if China continues to backstop the US economy). I assume this is the Fed’s view as well. If the Fed is in error, the yield curve should steepen dramatically in coming months. Bernanke & Co. would then be forced to reassess their policy choices.

Bottom Line: The combination of the Fed’s statement and the likely path of data suggest another 25bp of easing in December. The global slowdown, dollar strength, and commodity reversal all leave inflation off the table as a concern. Only technical considerations or a dramatic improvement in financial markets would prevent the Fed from further cuts, but with the ability to pay interest on deposits, a zero interest rate is not an impediment to expanding the Fed’s balance sheet.

Indeed, this is almost certainly the policy focus at this point. Inflation hawks might be unsettled by continued rate cuts, but hawks have had little impact on policy outcomes in this cycle. Consequently, the safe bet has always been for additional easing – even when only 100bp remain.

Comments

[gabe borens...:]

The only thing that is horrid is this article.
Surely ,the economy has decelerated significantly in this quarter but the stockmarket had discounted two consecutive Depressions.
As the stability package (enhanced by the other measures )is fully implemented ,the U.S economy/stock market will stage unprecedented mega rally (also known as Gabe).
The unemployment level should bottom out shortly .
By the time we get to the second quarter of 2009,the GDP will be expanding at 5% clip.
The dollar momentum will continue ,as the dollar strength is a global recognition of the U.S currency as being the ultimate flight to quality.
U.S assets including the equities and the real estate wili be the primary beneficiaries of this massive dollar inflows.
For the investors who believe that the gold kilobars will be the new means of exchange ,I suggest buying knapsacks.
It is dollar liqudity and history of safety that will cause the gold prices to implode.
Enough of the "horrid" articles.The problems/issues have been identified
and addressed effectively.
U.s economy/market are heading for unprecedented rebound .

2008 Oct 30 04:13 AM

[Steven Hansen:]

gabe, this is the second post today that i have found you putting out this unsubstantiated puff. this post is based on a real document issued by the group that is mishandling our economy.

gabe, the key word is unsubstantiated. you are not babe ruth who points where you will hit the ball. show the evidence. and the 5% gdp growth prediction is ludicrous.

the reason for horrid articles is that it is hard to find positive economic indication. make my day gabe and post a positive article with support data. you are pumping the market.

2008 Oct 30 06:29 AM

[MSmailbox:]

The dollar offers relative safety. How else could it be firming, in the face of massive rate cuts. Foreign investors have been reading the bumper stickers, which read, "BUY AMERICAN." I would add to this, North, Central and South American, because there are some great companies to our North and to our South.

Here's a thought! The dollar is rising, because the prices of US equities have fallen, over the past few months. The stock market is always the leading index, so that's why we are just beginning to see a bull market in the USD. The US dollar must rise inversly, as US equities fall. You own company xyz and it's fundamentals haven't changed over the past 14 months, but it's lost 67% of it's value, in USD. Obviously, since the company hasn't changed, the USD must rise in order to preserve "capital mass." Looking ahead, the stock market must rally and rally big, or we are faced with a USD that could double in value, very soon. :-)

2008 Oct 30 12:02 PM

[Billy Hallo...:]

Great piece. Times are scary, no? The U.S. economy has surely taken quite a hit over the past few months. With a recession and the need for reform on the minds of a majority of Americans, I thought you might be interested in two non-partisan guides we’ve put together here at Public Agenda on the economy (publicagenda.org/citiz...) and taxes, spending and debt (publicagenda.org/citiz...). Feel free to check these out and get back to me with any questions. Thanks again for an informative piece!

2008 Oct 30 04:20 PM